Question of the Day

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It’s the Federal Reserve’s job to set monetary policies that maintain price stability and promote maximum sustainable growth in output. Economic forecasting is central to this task. Among the many economic variables regularly forecast at the Fed, none is more important than inflation. It’s also one of the most difficult variables to predict.

Since Fed inflation forecasts directly influence monetary policy, in particular short-term interest rates, it’s relevant to inquire how the forecasts are made and how accurate they are.

Prior to each meeting of the Federal Open Market Committee (FOMC), the group that sets the federal funds interest rate, Federal Reserve Board staff economists distribute their forecast to committee members. Individual members may not always agree with the staff forecasts, but they nevertheless carry considerable weight.

The Fed staff forecasts are judgmental — though with the benefit of a variety of economic models, inputs and analyses — and are consistent with an assumed future path for monetary policy. Judgmental predictions are preferred since models based on past data cannot adequately factor in new developments, nor build in qualitative information or intuition.

In remarks to a research forum in Germany on May 20, Federal Reserve Gov. Donald L. Kohn spoke about inflation modeling at the Fed and presented a chart showing board staff forecasts of inflation for 1984 to 2000. (Later data were not given, since staff forecasts are kept confidential for five years.)

For each quarter, the value forecast was the percent change four quarters ahead in the core Consumer Price Index (the index excluding food and energy), a measure of underlying inflation.

A comparison showed two-thirds of inflation forecasts were within a half-percentage point of what actually occurred. In other words, a third of the time the actual price change was more than a half-point higher or lower than predicted.

For 1984-2000 as a whole, the staff forecast was slightly higher than the actual increase, by an average of about 0.2 percentage points yearly. Unsurprisingly, forecast errors were larger when inflation rates were high. Still, the forecast overall was distinctly better than predictions based on extrapolating the inflation trend of the four preceding quarters.

Various causes were noted by Mr. Kohn for off-the-mark staff forecasts. Sometimes demand was overestimated, or unanticipated changes in the value of the dollar or in oil prices fed into core prices. Mr. Kohn thought the upward bias in the forecasts could have been due to labor market developments that affected the natural or noninflationary unemployment rate, such as more disabled unemployed withdrawing from the labor force and increased unwillingness to risk leaving jobs to search for others because of growing insecurity in the early 1990s.

Late 1980s estimates could have had upward biases, Mr. Kohn thought, because inflation expectations were not as great a problem as the forecast assumed. Also, the effect of the dollar decline on inflation could have been overestimated. Staff overestimates of inflation in the mid-1990s were probably due to an unanticipated improvement in productivity growth.

We will have to wait to get access to Fed staff forecasts for the years since 2000. But, as Mr. Kohn said: “Forecasters everywhere did not anticipate the extent of disinflation in the U.S. economy in 2003. … Moreover, the degree to which core inflation picked up in 2004 and 2005 also caught many economists, including this one on the FOMC, by surprise.”

In addition to the staff forecasts, the Federal Reserve governors and bank presidents make their own forecasts of inflation, as well as gross domestic product and unemployment, which they report twice a year to Congress.

Early this year these Fed policymakers estimated core inflation as measured by the Commerce Department’s chain-type personal consumption expenditures price index would rise between 11/2 and 13/4 percent from the fourth quarter of last year to the fourth quarter of this year. So far they’re on target.

The Fed seems to have done a good job forecasting inflation, merging modeling with judgment. Fortunately, judgment has prevailed over econometrics, reflecting the wisdom and long experience of the current Fed chairman.

Alan Greenspan’s term is nearing its end, and next year we will have a new chairman. It’s important that whoever it is have a sense of analytical balance, such as the current chairman has. Policymaking is very much an art, as is forecasting.

Alfred Tella is former Georgetown University research professor of economics.

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